May 1, 2015

Balance U.S. Trade with a MAC Attack on Currency Misalignment


Responding to widespread pressures from the American public, many members of Congress are seeking to add language to the 'fast-track' or Trade Promotion Authority (TPA) legislation requiring that tough rules against currency manipulation be negotiated in the Trans-Pacific Partnership (TPP) agreement. This approach is highly unlikely to fix America's trade deficits for the following reasons:
  • The TPA bill simply repeats ineffective language similar to what has been in the IMF's rule books for years.
  • It does nothing to provide an enforcement mechanism.
  • It focuses only on currency manipulation by TPP members, totally ignoring the much bigger and more important problem of overall currency misalignment.
As promised in my previous post, an alternative policy is presented here that avoids the above problems and offers real promise of increasing the international competitiveness of America's factories and workers, stimulating growth and employment, and bringing America's imports and exports back into balance.

These highly desirable goals could be accomplished by moderating the inflow of foreign capital to levels consistent with America's need for foreign financing and with the economy's ability to use such capital efficiently. With this, Congress could prevent the overvaluation of the dollar caused by excessive foreign demand for dollars and dollar-denominated assets.

Why a New Mechanism is Needed to Balance U.S. Trade in the 21st Century

According to Econ 101, when market demand for any good or service exceeds its supply, the price will rise, leading to rising supply and falling demand. Ultimately, supply and demand will be rebalanced by this interplay of natural market forces.

Unfortunately, Econ 101 may work fine in balancing domestic demand and supply for simple commodities such as apples, but it fails miserably in today's world to balance global demand and supply for America's financial assets, such as shares of Apple, at an exchange rate for the U.S. dollar that also balances America's external trade in goods and services. Explaining the reasons for this failure would require a separate note – or book, but the fundamental problem is as follows.

The market in which the exchange rate for the dollar was traditionally set was the market for America's imports and exports of goods and services like apples, cars, machine tools and design work. For hundreds of years, exchange rates were established in this manner – and still are for most countries other than those issuing "reserve" currencies like the dollar, the euro, and the yen. Since exchange rates were determined primarily by sales and purchases of real goods and services, which are recorded in the current account of the balance of payments, exchange rates naturally tended to balance the demand for real imports and exports – just like Econ 101 would predict.

However, world trade has changed dramatically in the past half-century. The dollar's value now is determined largely by trade in capital assets such as currencies, stocks, bonds, and other financial securities. The absolute volume of such monetary transactions, which are recorded in the capital account of the balance of payments, vastly exceeds global transactions in real goods and services. Furthermore, capital account transactions take place in markets that operate with little direct linkage to current account transactions in real goods and services.

In the past few years, for example, capital account transactions and thus the dollar's exchange rate have largely been driven by developments such as conflicts in the Middle East, the Eurozone crisis, and plans of the Federal Reserve to taper its quantitative easing program. These developments, which led to a dramatic outflow of capital from countries outside the U.S., created an exceptionally high demand in America for dollar-denominated capital assets. These "capital account" developments, not a sudden "current account" demand for real made-in-America goods and services, drove the dollar's sharp appreciation during the past year.

In short, because the dollar's value today is determined largely by capital account rather than by current account transactions, any connection between the exchange rate set by such capital transactions and the exchange rate needed to balance America's imports and exports of real goods and services on the current account of the balance of payments is pretty much an accident.

Consequently, if America wants to balance its external trade, thereby assuring that ordinary Americans can earn as much producing exports as they spend on imports, it can no longer depend on the same market mechanisms that worked in the non-financialized world of previous centuries. If it really wants to put thousands of American factories and millions of American people back to work, Congress needs to establish a market-based mechanism that will balance trade in the real world of the 21st century.

Market Access Charge

The most promising policy for doing this is a Market Access Charge (MAC). In a nutshell, a Market Access Charge would help balance the demand and supply for America's capital assets by moderating foreign demand for such assets when demand becomes excessive, causing the dollar's exchange rate to rise to levels inconsistent with balanced current account trade in goods and services.

This approach is called a "Market Access Charge" or MAC because it would raise the cost to foreigners of accessing America's financial markets when the demand for securities in these markets is excessive. 

The MAC is nothing more than another form of peak-load-pricing, a well-known market-based mechanism used widely by both the private and public sectors in the U.S. and abroad to keep demand consistent with supply. Good examples are peak-load and off-peak pricing for electricity, rental cars, movies, resorts, access by private car to city centers, and the like.

Unlike the old-fashioned and rightly condemned  capital controls of the past that were designed to restrict cross-border flows to specific levels using direct and often discriminatory administrative controls over individual transactions, the MAC is a totally market-driven, level-playing-field approach that fully meets all IMF requirements for capital flow management tools.

A Market Access Charge would go into effect whenever the U.S. trade deficit exceeds one percent of GDP – indicating that the dollar is far enough away from its trade-balancing exchange rate to cause significant trade deficits.

Trade deficits are bad for America, not only because they create debt liabilities to foreigners that future generations of Americans must deal with, but also because the deficits cause significant underemployment today of U.S. assets including labor, factories, and infrastructure. In a word, trade deficits reduce economic efficiency and growth. 

American assets lie idle when we borrow money from countries like China to pay them to produce goods for us with their workers and their equipment. Many of the goods we import today from China and elsewhere could easily be produced at internationally competitive prices by American workers in America's own factories if the dollar's exchange rate were at its trade-balancing equilibrium level rather than at today's inflated rate.

Given that much of the capital flowing into the United States comes in search of tiny speculative margins – often just a few basis points or fractions of a percent, a MAC introduced at a very low rate  – say 25 to 50 basis points – would still have a substantial moderating effect on total capital inflows.

While this low charge would discourage much of the speculative trading that drives up the dollar's exchange rate, it would have no impact on serious investors interested, for example, in building or expanding an industrial plant in the United States. Such projects frequently involve returns in the range of 10-15 percent per year over a life span of 15-20 years. For serious direct investors, a one-time charge of 25-50 basis points would therefore be immaterial. In fact, daily swings in the Euro-Dollar exchange rate are far larger.

If an initial MAC charge of 25-50 basis points had the desired impact on capital flows and thus on the dollar's exchange rate as indicated by a falling external trade deficit, the MAC rate would automatically return to zero. Conversely, if the trade deficit continued to grow relative to GDP, the MAC rate would automatically be increased in transparent, pre-announced increments linked to the size of the trade deficit – then be reduced as the deficit shrank back towards one percent of GDP.

To avoid efforts by foreign investors to evade the MAC by claiming that they were bringing in capital for some purpose not subject to the charge, then using it for a different purpose, the MAC would apply equally to all capital inflows, regardless of source, ownership, or purpose. The playing field would be totally flat and non-discriminatory.

An objective, automatic mechanism like this should have great appeal to policy makers and to Americans in general who are sick and tired of seeing politicians sacrifice America's economic future to "strategic concerns" and "special interests."

The MAC is Superior to Other Options Now on the Table

The MAC avoids the following problems that would almost certainly doom the legislative proposals currently under consideration, proposals designed to fix America's growing trade deficits by imposing penalties on currency manipulation.

First, currency manipulation is hard to define. Most definitions of currency manipulation currently on the table, including those of the IMF, have big loopholes that could easily be exploited by countries wanting to manipulate currencies.

Second, existing definitions of currency manipulation, for example, require proving that a country is invoking currency-related policies with the intent to gain competitive international advantage in international trade.  Yet, although Japan's dramatic monetary easing is clearly having a major impact on the yen/dollar exchange rate, under existing rules, Japan can legitimately claim that its intent is only to provide a domestic economic stimulus. Incidentally, this problem will not be eliminated with a tighter definition of currency manipulation because doing so could make American polices like the Fed's own quantitative easing program illegal.

Third, measuring currency manipulation is very difficult, especially in the context of legislation such as the "Currency Exchange Rate Oversight Reform Act of 2013" that attacks currency manipulation as an illegal subsidy. Determining the size of the subsidy to be countervailed and thus the size of the currency-based countervailing duty to be applied to specific imports requires calculating the difference between the effective market exchange rate and the equilibrium exchange rate of the manipulating country's currency. The latter value in particular is notoriously hard to calculate, can vary widely depending on assumptions made, and can change quickly depending on economic developments.
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In contrast, the MAC would be easy to implement because it is tied to an empirically measurable and regularly published indicator – the U.S. trade deficit relative to GDP. Furthermore, the MAC complies fully with all international trade and finance laws, as well as with all U.S. treaty obligations. It is transparent, temporary, targeted, and non-discriminatory as required by  IMF guidelines (p. 20). It is automatic, thus reducing the risk of political interference. And if needed, it can legally be implemented unilaterally by the United States with no risk of starting a trade war. In fact, if other deficit countries such as those in the southern periphery of the eurozone were to "retaliate" by implementing their own MAC's, everyone would be better off.

America Needs a Competitive Dollar - Now!